In Veriha,
the Tax Court held
that the Sec. 469
self-rental rule
applied to a taxpayer
who owned three
companies, a trucking
company and two
truck-leasing
companies, and thus
the income from the S
corporation
truck-leasing company
should be
recharacterized as
nonpassive, while the
losses from his LLC
truck-leasing company
should remain passive.

In Quality
Stores, Inc.,
the Sixth Circuit held
that severance
payments paid to
terminated employees
as a direct result of
a workforce reduction
are not subject to
FICA tax.

In Rev. Rul.
2012-18, the IRS
issued guidance about
FICA taxes imposed on
tips and the
procedures for notice
and demand for those
taxes under Sec.
3121(q). Under
Announcement 2012-50,
the rules
distinguishing between
tips and service
charges in the revenue
ruling will not apply
until Jan. 1, 2014.

This article covers
recent developments in
individual taxation. The items
are arranged in Code section
order.

Sec. 1:Tax Imposed

The
First and Second Circuits found
Section 3 of the Defense of
Marriage Act (DOMA)
unconstitutional.1 The
effect of Section 3 is to deny
federal income tax benefits,
such as filing joint income tax
returns, to same-sex couples.
The First Circuit stayed its
mandate that Section 3 not apply
pending a likely Supreme Court
review. The Supreme Court has
granted certiorari
in the Second Circuit case and
will hear arguments on March
27.

Sec. 24:Child Tax Credit

Children of a U.S. citizen
and her Israeli spouse, who were
born and living in Israel, did
not qualify as dependents under
Sec. 152(b)(3), which states a
dependent must be a citizen or
resident of the United
States.2
Therefore, the child care and
child tax credits under Sec. 21
and Sec. 24 were denied. The
taxpayer also claimed that the
IRS’s alternative argument that
the credits were being denied
because she did not file a joint
return, as required by Sec.
21(e), was prohibited by Sec.
7522 because the notice of
deficiency did not mention Sec.
21(e). The Tax Court noted Sec.
7522 does not require the IRS to
identify all of the Code
sections applicable to each tax
adjustment.

Sec. 61: Gross
Income Defined

In Notice
2012-12,3 the
IRS provides that mandatory
restitution payments that
victims receive from defendants
under 18 U.S.C. Section
15934 are
excluded from income.

Sec. 104: Compensation for
Injuries or Sickness

In
Blackwood,5 the
taxpayer was terminated from her
job for accessing her son’s
medical records at the hospital
where she worked. In the
taxpayer’s unlawful termination
suit, she indicated she suffered
from a relapse of depression
symptoms. The taxpayer received
$100,000 and a Form 1099-MISC,
Miscellaneous
Income, reporting the
payment, but the taxpayer did
not report it on her tax return
because she believed it was
excludable under Sec. 104.

The Tax Court held for the
IRS that the damages were not
excludable under Sec. 104(a)(2)
even though the underlying
action was based on a tort or
tort-type right. The taxpayer
was unable to show she received
damages for physical injuries. A
letter from her doctor did not
note any physical symptoms. The
flush language of Sec. 104(a)
also did not help the taxpayer’s
case because it states that
“emotional distress shall not be
treated as a physical injury or
physical sickness.” She was also
unable to benefit from Sec.
104(a) because she did not show
that she used any of the damages
for medical care for emotional
distress.

Sec. 107:
RentalValue of
Parsonages

The Supreme Court declined
to hear the taxpayer’s appeal
in Driscoll.6 This case involved how
the word “a” in the Sec. 107
exclusion from gross income
for the rental value of a
parsonage should be
interpreted when used in the
phrase “a home.” Does that
mean one home or could it mean
two homes? The Tax Court held
for the taxpayer, noting that
“a home” could have a plural
meaning. On appeal, the
Eleventh Circuit held for the
IRS, noting that “home” has a
singular meaning and that
income exclusions should be
construed narrowly.

Sec. 108: Income From
Discharge of Indebtedness

In a case decided by the Tax
Court, the taxpayers did not
qualify to exclude income from
discharged credit card debt
under the exclusion for
insolvency in Sec. 108(a)(1)(B)
due to a lack of credible
evidence presented regarding the
fair market value (FMV) of their
assets immediately before the
discharge.7 The
evidence they submitted was
insufficient to establish FMV
for federal tax purposes because
the documents (tax bills and
loan documents) did not describe
the property or explain the
methodology used to determine
the value, and their testimony
regarding comparable sales was
uncorroborated and was not based
on contemporaneous sales.

Rev. Rul. 2012-148
amplifies Rev. Rul. 92-539 and
explains how partners treat a
partnership’s discharged excess
nonrecourse debt in measuring
insolvency under Sec. 108(d)(3).
To the extent discharged excess
nonrecourse debt generates
cancellation of debt (COD)
income that is allocated under
Sec. 704(b) and its regulations,
each partner treats its part of
the discharged excess
nonrecourse debt related to the
COD income as a liability in
measuring insolvency under Sec.
108(d).

In Letter Ruling
201228023,10
the IRS found that a parent
corporation’s bankruptcy plan
was considered a liquidation
plan for tax purposes. None of
the debtors will recognize COD
income with respect to any of
the allowed claims until all
distributions are made or if the
bankruptcy plan ceases to be a
liquidation plan.

Sec.
162: Trade or Business
Expenses

After the IRS
denied a taxpayer’s deduction
for moving expenses, the
taxpayer agreed but then tried a
uniquely different approach in
Tax Court.11 He
tried to claim meals, lodging,
and lease cancellation fees as
business expenses related to his
employment as a restaurant chef.
The IRS and the court both
agreed that he had changed his
tax home when he moved himself
and his family and therefore no
deduction was allowed.

The IRS issued proposed regulations12that would allow a
deduction under Sec. 162 for
certain local lodging expenses
incurred by employers or their
employees. The deduction would
be allowed under a
facts-and-circumstances test.
One factor considered in
the test is whether the
expense is incurred to satisfy
a bona fide requirement
imposed by the employer. In
addition, the regulations
contain a safe harbor allowing
the deduction in the following
circumstances: (1) The
lodging is necessary for the
person to fully participate or
be available for a bona fide
business function; (2) it does
not exceed five calendar days or
occur more frequently than once
a quarter; (3) the individual is
an employee, and his or her
employer requires him or her to
remain at the function
overnight; and (4) the lodging
is not lavish or extravagant and
provides no significant personal
pleasure or benefit. A
simplified version of these
rules was already in effect
under Notice
2007-4713 (which was made obsolete
by these
regulations).

DeLima14
could be used as a teaching tool
for all the ways taxpayers can
fail to substantiate their
Schedule C, Profit
or Loss From Business,
trade or business expenses. The
court went through a top 10 list
of problems with the claimed
expenses including:

Failure to provide
credible evidence on the
relative amount of business
vs. personal use of her
vehicles;

Failure to establish a
business purpose for various
expenses, including insurance
costs, furniture rental, or
lawn maintenance;

Failure to provide
receipts or other proof of
equipment purchases and
rentals;

Admitting that her rented
home and apartment were
entirely mixed
personal/business use; and

Failure to meet
the strict substantiation
requirements of Sec. 274(d)
for travel and entertainment
or listed property expenses.

In addition, the
taxpayer tried to claim that the
IRS examination was barred by
statute, even though she had
signed a Form 872, Consent
to Extend the Time to Assess
Tax. This argument and
her claim that she had signed
the Form 872 under false
pretenses were not raised until
after the actual trial, and the
court rejected them both.

Sec. 163: Interest

In Abarca,15
the petitioner claimed mortgage
interest expense deductions for
various rental properties on
Schedule E, Supplemental
Income and Loss, some
of which were purportedly owned
in partnership with others. The
petitioner was neither named as
the borrower for any of the
mortgages on these properties
nor was he able to prove he was
the properties’ legal or
equitable owner. In addition, it
was unclear whether the
properties had been contributed
to the various partnerships. It
was also apparent that the
partnership form was not
respected as the petitioner
reported the properties as if he
owned them individually. In
addition, the petitioner was
unable to prove that he
personally paid all of the
interest that he claimed. The
petitioner was denied the
deductions for any of the
mortgage interest claimed on
Schedule E for the subject
properties.

The Tax Court held in Chrush16 that the petitioner
failed to substantiate
payments of mortgage interest
on Form 1098, Mortgage
Interest Statement, and home mortgage
interest not reported on Form
1098. The petitioner co-owned
the house with a close friend,
but the amount reported on the
Form 1098 issued to them was
far lower than the deduction
the petitioner claimed on his
tax return, and no bank
statements, canceled checks,
or other evidence was produced
to substantiate that he paid
the claimed interest that was
not reported on the Form 1098.
In addition, the petitioner
was unable to prove that he,
and not his co-borrower, paid
the interest reported on the
Form 1098.

Sec.
165: Losses

In Chief
Counsel Advice (CCA)
201213022,17 an
indirect investment in a Ponzi
scheme was found to constitute a
theft loss under Sec. 165, even
though the taxpayer had not
invested directly with the
organizer (perpetrator) of the
Ponzi scheme. The IRS noted that
the “[p]erpetrator intended to
appropriate Taxpayers’ property
from Taxpayers.”

In Ambrose,18
the taxpayers suffered a loss
due to a fire in their home. The
damage was repaired by their
insurance company, but the
following month their home was
destroyed by another fire.
Insurance claims were filed, but
a dispute arose over whether the
damage was covered. The
taxpayers amended their return
to claim a casualty loss
deduction, and the IRS denied
the loss for failure to file an
insurance claim under Sec.
165(h). Although the homeowners
had filed a claim within four
hours of the fire, they did not
timely submit proof of loss to
the insurance company. The court
held that the taxpayers were
within the statute because they
had filed a “claim.” This case
includes extensive background on
the origin of the “file a claim”
requirement of Sec. 165(h).

In Letter Ruling
201240007,19 a
taxpayer was charged with
insurance fraud and settled a
suit with the insurance company
by making payments to the
company. The taxpayer was also
charged under state law and
entered into a plea agreement
that called for restitution
payments. The IRS determined
that both of the payments
qualified as restitution, which
is deductible under Sec.
165(c)(2), as long as the income
had been included in the
taxpayer’s gross income in prior
years and he received no
contribution from any other
party.

Sec. 170:
Charitable, Etc., Contributions
and Gifts

In Bentley,20 a
lawyer tried to deduct his
charitable contributions on
Schedule C rather than Schedule
A, Itemized
Deductions. At trial, he
refused to testify regarding the
claimed donations, instead
choosing to “rest on the
administrative file.” Not
surprisingly, the court
concluded that the deductions
were not an ordinary and
necessary business expense.
Since his itemized deductions,
even with the additional
charitable contributions allowed
on Schedule A, were below the
standard deduction, the assessed
deficiency was upheld. Somewhat
surprisingly, though, the court
used its discretion to refuse to
impose a sanction under Sec.
6673 (penalty imposed on a
taxpayer who instituted a
proceeding primarily for delay
or whose position is frivolous
or groundless), requested by the
IRS.

An IRS tax compliance
officer was found to have
claimed dependency exemptions,
medical expenses, and
charitable contributions to
which she was not entitled.21 The court also imposed a
civil fraud penalty against
her. Among those whose
testimony contradicted the
taxpayer’s claim to be unaware
of the documentation and other
requirements were her husband,
her supervisor, and
representatives of seven
charities to which she had
claimed she made
contributions. Receipts were
found to be “doctored” and her
testimony to be inconsistent
and implausible.

The adage to “read the
instructions” was shown to be
vital in Mohamed.22 The court denied a
charitable contribution of
more than $18 million because
the taxpayers failed to get an
independent appraisal, attach
the proper information to
their Form 8283, Noncash
Charitable Contributions, or obtain the proper
documentation before their
return was due. The taxpayers
attempted to challenge the
validity of the regulations as
being arbitrary and
capricious, and argued that
they substantially complied
with them. The court ruled
against all their arguments.
The final paragraph of the
ruling is worth reading in its
entirety:

We recognize that this
result is harsh—a complete
denial of charitable
deductions to a couple that
did not overvalue, and may
well have undervalued, their contributions—all
reported on forms that even to
the Court’s eyes seemed likely
to mislead someone who didn’t
read the instructions. But the
problems of misvalued property
are so great that Congress was
quite specific about what the
charitably inclined have to do
to defend their deductions,
and we cannot in a single
sympathetic case undermine
those rules.

Conservation easement cases
continue to occupy a large
amount of time at the Tax Court.
In a number of these cases, the
appraisers relied on an article
written by Mark Primoli of the
IRS, “Façade Easement
Contributions,” which indicated
that the IRS generally
recognized that donation of a
façade easement resulted in a
loss in value of 10% to 15%. The
article has since been revised
to omit that statement. In Scheidelman,23
the Second Circuit overturned
the Tax Court’s rejection of an
appraisal that relied on this
article and another Tax Court
case. (For more on façade
easements, see Durant, “First
Circuit Breathes New Life Into
Façade Easement Deductions,”
on p. 154.)

The Tenth Circuit upheld
the Tax Court’s ruling in Trout
Ranch LLC,24 saying that the court had
used proper discretion in
incorporating post-valuation
data into its analysis. The
appeals panel noted that the
Tax Court had been mindful of
the risks involved and had
given the greatest weight to
sales that occurred within a
year of granting the
conservation easement.

Sec. 179: Election
to Expense Certain Depreciable
Business Assets

In CCA
201234024,25
IRS Chief Counsel determined
that costs associated with
placing a vineyard in service,
including prior-year capital
expenditures, could be expensed
under Sec. 179. In doing so, the
IRS declared that Rev. Rul.
67-5126 no
longer applied to Sec. 179. The
ruling hinged on the fact that
“the definition of §179 property
has significantly changed” under
the 1986 version of the
Code.

Sec. 183: Activities
Not Engaged in for Profit

In Parks,27
the Tax Court awarded a rare win
to a taxpayer on the question of
whether an activity was a trade
or business or a hobby when the
taxpayer had an extensive
history of losses. The taxpayer
was a teacher and athletic coach
who did private track coaching,
for which he had incurred
losses, sometimes substantial,
in every year from 2003 through
2010. The IRS audited his 2006
through 2008 returns,
reclassified his activity as a
hobby, and moved his expense
deductions from Schedule C to
Schedule A while limiting the
deductions to the amount of his
income. In analyzing the case,
the Tax Court used its
nine-factor analysis; while the
two profit factors weighed
against the taxpayer, five of
the remaining seven factors were
favorable (the other two were
neutral). (It is worth noting
that one of Parks’s trainees was
Ryan Bailey, who finished fifth
in the 100 meters at the 2012
Summer Olympics.)

Sec.
212: Expenses for Production
ofIncome

In a Tax Court case, the
taxpayer invested cash equal
to 25% of the total capital of
the joint venture he had
entered into with a Chinese
food production plant.28 After the plant had
serious financial
difficulties, the plant
recapitalized under Chinese
law, requiring additional
payments of 200,000 yuan from
the taxpayer, which the
taxpayer’s sister in China
paid. On his jointly filed
2007 and 2008 federal income
tax returns, the taxpayer
attached Schedule C, Profit
or Loss From Business, for the proprietorship
and deducted a debt expense of
$27,070.30 and $29,099.80 for
2007 and 2008, respectively.
The IRS issued a notice of
deficiency and disallowed the
claimed debt expenses. The Tax
Court upheld the deficiency,
finding that the taxpayer did
not make any of the debt
repayments, but instead
claimed that payments his
sister made on his behalf
should be attributed to him,
despite the lack of evidence
of an agreement to repay his
sister.

Sec.
215: Alimony, Etc. Payments

In Doolittle,
alimony deductions were
disallowed for a husband for
amounts that were paid to the
wife by a qualified trust under
a qualified domestic relations
order.29 In
2008, the petitioner, who had
been paying monthly alimony for
a number of years after his
divorce, entered into a new
agreement to pay his former wife
$52,000 from a securities
account within 30 days. Under
the agreement, the qualified
trust was obligated to make the
payments, not the petitioner
himself. On his 2008 Form 1040,
U.S.
Individual Income Tax
Return, the petitioner
claimed a deduction for alimony
of $10,800, which was $900 of
monthly payments that were
required to be paid to his
former wife in 2008. Under Sec.
215, the alimony deduction is
allowed only to individuals, and
“not allowed to an estate,
trust, corporation, or any other
person who may pay the alimony
obligation of such obligor
spouse.” Because the
petitioner’s obligation was paid
by a trust, the petitioner was
not entitled to claim the
alimony deduction.

Alimony deductions were
disallowed for a husband even
though there was an oral
understanding between the
husband and his former wife
about the alimony payments.30 The petitioner and his
wife had informally separated
in 2004 and filed for divorce
in 2008. During this time, the
petitioner had paid $2,605 per
month to his former spouse and
their child, which was not
separated into spousal or
child support payments. On
Dec. 1, 2008, a judgment for
the dissolution of the
marriage provided that $1,400
per month would be paid for
alimony to the former spouse,
until either party died.
Before that time, the parties
had a mutual understanding,
but because it was not in
writing until Dec. 1, 2008,
the earlier payments could not
be deducted. The court stated
that this seemed unjust
because the parties had
already reached an
understanding of the amounts,
and that the agreement had
already been approved by a
court, but Congress had always
required a written document.

Sec. 262:
Personal, Living, and Family
Expenses

A Tax Court case
provides a great example of the
methods the IRS uses to audit
tax returns with Schedule
C.31
The IRS used a combination of
methods, including bank account
analysis, to reconstruct income
and examine the taxpayer’s
substantiation in the case of
expenses. Tax Court Rule 142(a)
states that deductions are a
matter of legislative grace, and
the taxpayer bears the burden of
proving that he or she is
entitled to any deduction or
credit claimed. Additionally,
the taxpayer must substantiate
all expenses for which a
deduction is claimed under Sec.
274(d) (travel expenses for
meals and lodging while away
from home). Under the Cohan32
rule, estimates can be used for
some expenses (although not for
Sec. 274 expenses) if there is a
basis for the estimation. In
this case, however, several
checks written to the owner of
the company with notations in
the memo section, such as “A/C
Repair,” were not otherwise
substantiated and were therefore
disallowed as personal expenses
under Sec. 262.

Practice
tip: With
reports of increased Schedule C
audits, this case provides a
great example for explaining the
audit process to a client.

In Nolder,33
the taxpayer was an
over-the-road truck driver who
completed Form 2106, Employee
Business Expenses, to
deduct expenses he incurred
while traveling. Several
expenses were disallowed as
personal under Sec. 262,
including uniforms that were
suitable for personal wear, ATM
withdrawal fees, and identity
theft insurance purchased due to
concerns of identity theft while
traveling to a town near Mexico
(the driver frequently had to
show identification). This case
is also a good reminder to ask
clients if a reimbursement plan
for employee expenses is
available to them. If a plan is
available, employees cannot
deduct the expenses even though
they do not participate.

Sec. 269:Acquisition Made to Evade
orAvoid
IncomeTax

The husband-and-wife owners
of a group of McDonald’s
restaurants in Utah established
two companies, an operating
company and a management
company, which they both owned
equally.34
The petitioners established a
profit sharing plan for the
benefit of the management
company employees, which
performed poorly. It was
terminated by establishing an
employee stock ownership plan
(ESOP) in its place, which in
turn owned 100% of the stock of
the new management company,
which elected to be an S
corporation.

In 2002, the
management company also created
a nonqualified deferred
compensation plan (NQDCP) for
the benefit of senior officers
and employees. The petitioners
elected to participate in the
NQDCP and deferred $3.066
million over three years. Since
a large portion of the
management company’s profit
consisted of the deferred
compensation, the money was
unavailable for distribution to
the ESOP. Even though the
management company was
profitable, the ESOP, which was
the sole shareholder, was not
taxed on this income. Due to the
large amount of money the
management company committed to
pay the NQDCP, the stock of the
management company had little
value. This negatively affected
the value of the rank-and-file
employees’ beneficial interest
in the ESOP.

In July
2004, the petitioners made the
following decision because
regulations under Sec. 409(p)
would cause them to include all
of the deferred compensation in
their income: sell the
management company stock to
petitioners for FMV and have the
management company pay to
petitioners the $3.066 million
deferred compensation and
terminate the ESOP.

By
creating two short years for the
management company, the
management company generated a
loss of $2.969 million, mostly
for distribution of the NQDCP.
The petitioners recognized
$3.066 million in ordinary
income from the NQDCP and offset
the income with the loss.

The IRS argued that the loss
generated was prohibited by Sec.
269 as a transaction to avoid or
evade income tax. The court,
siding with the petitioners,
said, “Petitioners were entitled
to arrange their affairs so as
to minimize their tax liability
by means which the law
permits.”

Sec. 280E:
Illegal Sale of Drugs

A
taxpayer was not allowed a
deduction for cost of goods sold
in connection with his medical
marijuana business.35
The taxpayer argued that he was
not trafficking in an illegal
substance and was operating a
caregiving business to indigent
individuals in need of medical
marijuana. The Tax Court held
that the operation of his
business still fell under Sec.
280E and, therefore, disallowed
the deduction.

Sec. 469:
PassiveActivity
Losses and Credits Limited

In Veriha,36 the petitioner owned
three companies: a trucking
company (C corporation) and
two equipment leasing
companies (one operated as an
S corporation and the other as
a single-member limited
liability company (LLC)). The
sole customer of the two
leasing companies was the
petitioner’s trucking company.
The petitioner’s leasing
companies had separate lease
agreements with the trucking
company for each piece of
equipment leased from the
respective company. For the
year in question, one of the
leasing companies realized
overall net income, while the
other company realized a net
loss. The petitioner claimed
that both the income and
losses came from a passive
activity and that all the
tractors and trailers he owned
as a whole should be
considered a single “item of
property.” The court disagreed
and stated that each tractor
and trailer was an “item of
property” of its own under
Regs. Sec. 1.469-2(f)(6),
which requires income from an
item of property rented for
use in a nonpassive activity
to be treated as not from a
passive activity. Therefore,
the net income the S
corporation generated was
recharacterized as nonpassive
income, and the net loss from
the LLC leasing company
continued to be characterized
as passive (under the
self-rental rule). The IRS did
not object to the petitioner’s netting the profitable
leases with the unprofitable
leases within the same company
to determine the company’s
overall net income or loss
from leasing
activities.

In Chambers,37 the Tax Court held that
the petitioner was not a
qualified real estate
professional and therefore
disallowed his losses from
rental real estate. In
addition, because his adjusted
gross income for each year
exceeded $150,000, the
petitioner was not entitled to
deduct $25,000 of losses from
rental real estate activities
under Sec. 469(i). The court
did not uphold
accuracy-related penalties
because the petitioner had
reasonable cause to believe he
was a qualified real estate
professional. The petitioner
and spouse, who both worked
full time in civilian
positions for the U.S. Navy,
owned one rental property
directly. In addition, the
petitioner owned 33% of an LLC
that held four rental
properties. Although the
petitioner was unable to
substantiate that he performed
more than one-half of his
personal services in real
property trades or businesses
in which he materially
participated as required under
Sec. 469(c)(7)(B)(i), his
belief that he satisfied these
requirements was reasonable.

Sec. 1001:
Determination of Amount and
Recognition of Gain or Loss

The Sixth Circuit affirmed
the Tax Court’s decision that
a shareholder’s transfer of
floating rate notes to Optech
Limited in exchange for a
nonrecourse loan equal to 90%
of the loan’s FMV was a sale
and not a loan because the
taxpayer transferred the
burdens and benefits of owning
the notes.38 The taxpayer sold over $1
million of low-basis stock in
his company to an ESOP and
then used the proceeds to
purchase floating-rate notes
in the face amount of $1
million. He then transferred
the notes to Optech in
exchange for a payment of 90%
of the value of the notes. The
loan agreement gave Optech the
right to receive dividends and
interest on the notes. The
court held that the
transaction was similar to an
option in which the taxpayer
retained the right to sell the
notes, to transfer the
registration in his own name,
and to keep all interest. The
court also found that the
taxpayer was not personally
liable on the note because the
loan was nonrecourse.

The IRS issued a
letter ruling in which it
concluded that a conveyance of a
perpetual conservation easement
in exchange for mitigation
credits is a sale or exchange of
property under Sec. 1001.39

Sec. 1031: Like-Kind
Exchange

The IRS chief
counsel concluded that federal
income tax law, not state law,
controls whether exchanged
properties are of a like kind
for Sec. 1031 purposes.40

The Tax Court found that a
taxpayer failed to establish
that he acquired like-kind
property in exchange for three
residential properties because
the taxpayer’s evidence was
incomplete.41

Sec. 1033: Involuntary
Conversions

In Notice
2012-62,42
the IRS provided a one-year
extension of the four-year
replacement period for certain
livestock under Sec. 1033(e) to
certain counties that
experienced droughts.

Letter Ruling 20124000643
involved the involuntary
conversion of a taxpayer’s
principal residence in a
presidentially declared
disaster. The taxpayer did not
report the gain on his return.
The IRS noted that under Regs.
Sec. 1.1033(a)-2(c)(2), the
taxpayer is treated as having
elected to defer gain from the
conversion because he did not
report the gain on the return
for the year in which the
insurance proceeds were
received. The IRS ruled that the
taxpayer can file original and
amended returns during the
replacement period to notify the
IRS of the acquisition of
replacement property.

Sec. 1221: CapitalAsset Defined

The Tax Court rejected the
taxpayers’ claim that a
residential property be
allowed ordinary loss
treatment because the property
was not held for sale to
customers in the ordinary
course of their trade or business.44 The court found that the
taxpayers did not intend to
occupy the property as their
personal residence, but the
property was never converted
from residential to
nonresidential property.
Because the taxpayers’ real
estate sales lacked frequency,
the court found the loss to be
a capital loss.

In another case, the court
found that income from the
sales of real estate lots was
ordinary income instead of
capital gain as the taxpayers claimed.45 The court found that the
taxpayers’ actions were
conducted in the ordinary
course of a trade or business
and not for investment
purposes, even though one of
the taxpayers was a day
trader. The court found that
the frequency, continuity, and
substantiality of the sales of
the lots were significant in
comparison to the day-trader
activities.

The Ninth Circuit affirmed
a District Court’s decision
that a qui
tam award is ordinary income
and not capital gain.46 A qui
tam award is allowed under the
False Claims Act,47 which permits an
individual to bring suit
against a defendant that the
individual knows has submitted
a false claim to the United
States. The Ninth Circuit
found that the award did not
qualify as a capital asset
because the taxpayer did not
invest capital in return for
the right and there was no
accretion in value over cost
to any underlying asset.

Secs. 1401 and
1402:Tax on
Self-Employment Income

Compensation earned from
performance of services as an
employee is not
self-employment income,48 but compensation earned
by a U.S. citizen employed by
a foreign government in the
United States is an exception
to this general rule. In Weaver,49 the taxpayer worked for
the Consulate General of
Canada in San Francisco. The
court held that a payment to
the taxpayer after a period of
disability was severance pay
subject to self-employment
tax. The petitioner had
reported the payment as “other
income” not subject to
self-employment tax that was
paid on account of disability
and therefore did not
constitute wages. The
consulate had characterized
the payment as severance and
calculated the payment based
on the petitioner’s length of
service and salary. The court
agreed with the IRS that the
payment was subject to
self-employment tax since
severance pay is a form of
compensation for services.50

In another case, the
taxpayer was an employee of
the International Monetary
Fund (IMF).51 U.S. citizen employees of
the IMF are subject to
self-employment tax on that
compensation as no payroll
taxes are withheld. The
taxpayer did not self-assess
the self-employment taxes, but
the court relieved the
taxpayer of the penalties: The
accuracy-related penalty does
not apply to any portion of an
underpayment if there was
reasonable cause for, and the
taxpayer acted in good faith
with respect to, that portion
of the underpayment.52 (This is reminiscent of
Treasury Secretary Timothy
Geithner who worked at the IMF
and was not subject to
penalties when he mistakenly
did not pay self-employment
taxes.)

In an IRS Information Letter,53 the IRS responded to a
taxpayer’s question about its
position on whether
self-employment tax applies to
rental payments for farmland
by explaining that, although
rental payments are normally
exempt from the tax, rentals
of farmland for agricultural
purposes where the farmer
materially participates are
not exempt. Several years ago,
the Eighth Circuit had issued
a decision54 holding that these
payments were not subject to
the tax, but the IRS issued a
nonacquiescence to that decision.55 In the information
letter, the IRS reiterated its
intent to continue to litigate
the issue in cases outside the
Eighth Circuit and explained
that its interpretation of the
exception in Sec. 1402(a)(1)
best promotes Congress’s
intent that farmers who work
for a living have their
incomes replaced through
coverage under the Social
Security system.

The Tax Court held that a
trustee should be treated the
same as a director and a
director is not an employee:
The trustee is self-employed
and therefore liable for his
or her own Social Security and
Medicare taxes.56

Sec.
3101: EmploymentTaxes on Employees

The Sixth Circuit ruled in Quality
Stores, Inc.57 that severance payments
paid to terminated employees
as a direct result of a
workforce reduction are not
subject to FICA tax. In an
article discussing the Quality Stores decision, Laura Saunders
in her Wall
Street Journal Tax Report of Oct. 27,
2012, suggests: “If the
company didn’t file a refund
claim for FICA taxes but the
employee believes she is
entitled to one, then often
she can file IRS Form 843 [Claim
for Refund and Request for Abatement] to make her own claim,
according to an IRS spokesman.
But the worker must make the
claim during the statute of
limitations period, which is
usually three years after the
April 15 due date following
the year the severance was received.”58 The Sixth Circuit’s
decision conflicts with the
Federal Circuit’s 2008
decision in CSX Corp.59

A
U.S. district court held that
money an individual received to
settle an age discrimination
lawsuit constituted wages
subject to FICA tax withholding
because the individual failed to
prove otherwise.60

The Tax Court, sustaining
penalties and additions to
tax, held that a company was
liable for employment taxes on
wages paid to masons and
laborers the company argued
were independent contractors,
finding that the requirements
for relief under Section 530
of the Revenue Act of 197861 were not satisfied
because the company did not
file Forms 1099-MISC treating
the laborers as independent contractors.62 In addition, the court
concluded that the masons and
laborers were the company’s
employees, basing its decision
on common law principles.63

Sec.
3121: EmploymentTaxes

In Rev. Rul.
2012-18,64
the IRS issued guidance updating
guidelines regarding FICA taxes
imposed on tips and the
procedures for notice and demand
for those taxes under Sec.
3121(q) when employees failed to
report or underreported tips to
the employer. (The guidelines,
in question-and-answer format,
modify and supersede guidance
originally published in January
1995.65)
The new guidelines were supposed
to be effective immediately when
they were issued, but because
the tip vs. service charge rules
may require businesses to change
their automated or manual
reporting systems to comply, the
IRS announced that its examiners
were being instructed, in
limited circumstances, to apply
the rules prospectively to
amounts paid on or after Jan. 1,
2013.66
These deadlines were delayed
further, so they will now apply
to amounts paid on or after Jan.
1, 2014.67

Sec. 6013: Joint Returns of
IncomeTax by
Husband and Wife

A district court denied a
taxpayer’s duress defense to
joint and several liability
for a joint return she claimed
she signed while medicated and
her husband “threatened to
tear apart the family.”68 The denial was based on
discovery that showed the
spouses remained married while
living apart for 12 years
before filing the joint
return. Therefore, although
the court believed the wife’s
claims that she had been
subjected to emotional abuse
through most of her marriage,
by the time she signed the
return at issue, she was no
longer under duress. The wife
also admitted she had signed
the return believing the
husband would pay the income
tax liability.

Sec. 6015: ReliefFrom Joint and
SeveralLiability
on Joint Return

The Tax
Court denied a retired engineer
relief under Secs. 6015(b), (c),
and (f). The taxpayer claimed
that the taxable IRA withdrawals
he made should not be taxable to
him because he made them to
comply with a Colorado court’s
order to pay spousal and child
support.69 He
also claimed that the capital
gain on stock he sold to pay his
ex-wife should be attributed to
his ex-wife. The taxpayer’s most
interesting claim was that,
because he faced jail time if he
did not make the court-ordered
payments, he was a victim of
abuse, which he claimed made him
eligible for innocent spouse
relief. The court did provide
relief for the delinquency
caused by the ex-wife’s
unreported interest income of
$37.

Sec. 6673: Sanctions
and Costs Awarded by Courts

In the Ninth Circuit, a
taxpayer was found liable for
tax and penalties under Secs.
6651(a)(1) and (2) and 6654 for
the 2006 tax year and sanctioned
for making frivolous arguments
under Sec. 6673, affirming a Tax
Court bench decision.70
The taxpayer, an employee of
SkyWest Airlines Inc. (SkyWest)
for 2006, earned $78,758 in wage
income reported on Form W-2,
Wage
and Tax Statement, from
the airline. Additionally, the
taxpayer realized capital gain
income of $29,079, as reported
on a Form 1099-B, Proceeds
From Broker and Barter
Exchange Transactions.
Nonetheless, for that year, the
taxpayer filed a tax return
reporting zero wages and no
capital gains, arguing that he
was entitled to exclude his
income under Sec. 83. The
taxpayer claimed that he had
basis in his labor, which he
traded to SkyWest for
compensation of an equal value.
As a result, the taxpayer
asserted that under Sec. 83(a),
“the value of his labor is
excluded from gross income.”
Additionally, the taxpayer
argued that his wage income did
not qualify as wages under Sec.
3401(a) and Sec. 3401(b) and
that he was not an employee
under Sec. 3401(c).

The
Tax Court found that the
taxpayer’s arguments were the
result of a misguided reading of
the Code and that the taxpayer
constructed arguments based on
portions of the Code and
regulations that did not apply
to him. Based upon these
actions, the court upheld the
assessment of tax and penalties
under Secs. 6651 and 6654 and
imposed sanctions for making a
frivolous argument under Sec.
6673. The taxpayer’s “actions
reflect an appalling lack of
competent research and analysis
and suggest that he was
motivated by goals that are
simply not consistent with a
good-faith attempt to comply
with the obligations imposed on
taxpayers by the federal tax
system.”

Sec. 6702:
Frivolous Tax Submissions

In October 2012, a district
court upheld the IRS’s attempt
to collect unpaid federal income
taxes and penalties against an
individual for late filing,
failure to pay, and failure to
pay estimated tax penalties
under Sec. 6702.71
Before tax year 2000, the
taxpayer filed tax returns and
paid tax. In 2000, the taxpayer
began filing “zero” tax returns
and failed to report complete
and accurate information until
2009. Additionally, he requested
a refund for the 1999 tax year,
claiming that the taxes he paid
were illegal.

When the taxpayer did not
receive a refund and instead
was assessed a frivolous
return penalty, he met with an
IRS settlement officer and
said he would pay in full if
the officer could produce the
Code section that required him
to pay the tax. The taxpayer
believed that he had no duty
to pay and requested that his
employer not withhold any tax
for the years in question. In
2009, he began reporting
income and expenses properly.
The court found that the
“zero” returns filed for the
years at issue were frivolous
and proved that the taxpayer
did not make honest and
reasonable attempts to comply
with the law or exercise
ordinary business care and
prudence in filing his tax
returns and paying the tax.

Karl Fava is a
principal with Business
Financial Consultants
Inc. in Dearborn, Mich.
Jonathan Horn is a sole
practitioner
specializing in taxation
in New York City. Daniel
Moore is with D.T. Moore
& Co. LLC, in Salem,
Ohio. Susanne Morrow is
a tax partner with Ernst
& Young LLP in San
Francisco. Annette
Nellen is a professor in
the Department of
Accounting and Finance
at San José
State University in San
José,
Calif. Teri Newman is a
partner with Plante
& Moran PLLC in
Chicago. Miguel Reyna is
the sole owner of Reyna
CPAs PLLC in Dallas.
Kenneth Rubin is a
partner with RubinBrown
LLP in St. Louis. Amy
Vega is a senior tax
manager with Grant
Thornton LLP in New York
City. Donald Zidik is a
manager with McGladrey
LLP in Boston. Mr. Horn
is chair and the other
authors are members of
the AICPA Individual
Income Tax Technical
Resource Panel. For more
information about this
article, contact Mr.
Horn at jmhcpa@verizon.net.

The winner of The Tax Adviser’s 2014 Best Article Award is James M. Greenwell, CPA, MST, a senior tax specialist–partnerships with Phillips 66 in Bartlesville, Okla., for his article, “Partnership Capital Account Revaluations: An In-Depth Look at Sec. 704(c) Allocations.”

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